Tips From the Pros: A Tsunami in the Estate-Planning World

The American Taxpayer Relief Act of 2012 (ATRA), effective Jan. 1, 2013, subtlety emerging into our estate-planning life much the same way the iPhone has subtlety reduced our available free time, has had major impact on our practice as estate planners.

Quantitatively, not many estate and gift tax provisions were changed. The two most dominant alterations were an increase in the estate and gift tax exemption to what’s now an indexed $5.45 million amount and the advent of portability. 

But, those two changes have drastically altered the estate planner’s practice landscape in a variety of areas, including:

1. Type of estate tax plans and how to draft for them.

2. Advocacy of changing title between spouses.

3. Types of planning done for clients.

4. Internal Revenue Service reviews.

5. Development of new practice areas.

6. Commoditization.

7. Malpractice.

8. Domicile planning.

9. Life insurance.

10. Basis planning.

11. Unwinding of family limited partnerships. 

12. Charitable planning (specifically, charitable lead trusts).

13. Grantor retained annuity trusts. 

I’ll focus on the first item and how planners should have evolved their practice consistent with the impact of ATRA. In future columns, I’ll cover the other areas.

Building a Pyramid

Portability and income tax planning, which essentially have to be “wait and see” decisions until the first spouse passes away, have caused the estate plan documents to be potentially extremely complicated to construct. But, it needn’t be complicated if practitioners use the single fund qualified terminable interest property (QTIP) trust as the base of their clients’ planning.

Marital Deduction

Almost all of husband/wife estate planning involves a marital deduction, either an outright deduction or a trust benefiting the surviving spouse. Greater than 50 percent and probably closer to 75 percent to 80 percent of gifts to the spouse are in the trust format. Certain trusts qualify for the marital deduction and others don’t.  

Most trusts these days will be in a QTIP format to qualify for the marital deduction. The older variety, the general power of appointment trust, was popular pre-1982 and has been disappearing ever since. Moreover, because of portability, most trusts are set up with either a single fund QTIP or a credit shelter trust also qualifying for the QTIP, with the expectation that Revenue Procedure 2001-38 won’t interfere with a QTIP election done to increase the portability amount (that is, over a portion that otherwise wouldn’t be subject to estate tax because of the $5.45 million exemption amount). In that revenue procedure, to protect a taxpayer that mistakenly made a QTIP election—in essence to allow the rescission of the election—the IRS provided that a QTIP election made when there’s no need to reduce the estate tax (for example, the marital deduction won’t reduce the estate tax further) is void. Here, to allow for portability, the taxpayer would be making a QTIP election (so that the property is included in the surviving spouse’s estate), but not reducing the estate. Would such an election be void under that revenue procedure?

To Be or Not Be QTIP

A proper QTIP must include a mandatory income interest to the surviving spouse. (A mandatory income provision would read, for example: “The trustee shall pay to my spouse all income not less often than annually.” Note, it’s not discretionary.)  

Also, no individual, other than the surviving spouse, can be a beneficiary of the trust during the spouse’s lifetime. A trust that allows the trustee to distribute principal to either the spouse or children, even pursuant to an ascertainable standard, wouldn’t qualify.

And lastly, your client must make a QTIP election on the Form 706, Schedule M.  

Single Fund QTIP

In 1982, we spoke of the single fund QTIP endearingly. Post-2013, we should speak of it with reverence.

With the advent of portability, as well as divergent state inheritance tax statutes, the single fund QTIP may be the most practical strategy in will and trust drafting. One predicate needs to be noted: Rev. Proc. 2001-38 could imply that QTIP status isn’t “electable” if there’s already no estate tax. A recent private letter ruling confirmed this possibility.¹ That PLR also voided an unneeded QTIP election, but again, as with the Rev. Proc. 2001-38, it looked like the taxpayer made a mistake by not setting up a credit shelter trust (all trust property was included in Schedule M and a QTIP election deemed made) and that the IRS issued the ruling to help the taxpayer fix that mistake.²

That is, if a client’s gross estate was $5 million, he made no lifetime taxable gifts and his surviving spouse wanted to elect QTIP status, the PLR could be interpreted to prevent that election, because even without the election of QTIP status, there would be no estate tax.

The estate-planning community has advocated for clarification that QTIP elections in estate tax returns required only to elect portability are valid. I would hope the Treasury understands the practical reasons to practitioners to allow for this flexibility. Assuming the Treasury allows for this result, the single fund QTIP permits a practitioner to achieve the following for his client:

1. For the portability decision to be decided at the surviving spouse’s passing. Estates may want to include 100 percent of the property in the surviving spouse’s estate to achieve a step-up in income tax basis. The goal will be either to make a partial QTIP election to create a credit shelter trust out of the non-elected portion (the $5.45 million estate tax exclusion amount) or a full QTIP election to put all the property in the surviving spouse’s estate for basis step-up reasons.³

2. For state inheritance tax to be avoidable at the first spouse’s passing if that state has a QTIP marital deduction, even if that state has a credit that’s decoupled from the federal credit.

3. Ease in drafting.

4. Ease in client understanding.

5. Ease in administration until multiple trusts are created (post-mortem).

6. Commonality of trust terms.

Simple Drafting

The drafting world these days includes complicated forms made even more complicated because of portability, Clayton elections, state inheritance taxes and the $5.45 million current exemption.

The most simplified estate plan that incorporates all the possible trusts that should be created at the first spouse’s passing in a generation-skipping transfer (GST) plan typically reads:

3.3 Gifts if Spouse Survives. If my spouse survives me, then I make the following gifts:

(a) Non-qualified Property. I give the non-qualified property that is included in my estate for federal estate tax purposes to the trustee to hold as the GST Family Trust, but only to the extent that the value of this property as finally determined for federal estate tax purposes does not exceed my Available GST Exemption Amount. I give any remaining non-qualified property to the trustee to hold as the Family Trust.

(b) State Exempt Gift. I give the State Exempt Gift to the trustee to allocate in portions as follows: The trustee shall hold the GST State Exempt Gift portion as the GST Family Trust and shall hold the non-GST State Exempt Gift portion as the Family Trust.

(c) Excess Federal Exempt Gift. I give the Excess Federal Exempt Gift to the trustee to allocate in portions as follows: The trustee shall hold the GST Excess Federal Exempt Gift portion as the GST Election Trust and shall hold the non-GST Excess Federal Exempt Gift portion as the Election Trust.

(d) Residue Gift. I give the Residue Gift to the trustee to allocate in portions as follows: The trustee shall hold the GST Residue Gift portion as the GST Marital Trust and shall hold the non-GST Residue Gift portion as the Marital Trust.  

Really? Can a client understand that? Does a client want to understand that? Can you? Your fourth-year associate? How does portability play into this?

Life would be so much easier if your client had a bequest that said: “I give the balance of the Trust estate to the trustee to hold as the marital trust.”

And, you can draft such a bequest. 

Easy for the client to understand? You bet, and you can tell the client that he can decide on portability,⁴ the credit shelter and deferral of state inheritance tax. 

Marital Trust

Here’s what the marital trust should say regarding administration:

The trustee shall administer the Marital Trust as follows:

1.1 Mandatory Payment of Income. Beginning with my death, the trustee shall pay all the income to my spouse at least annually. Notwithstanding any other provision of this instrument, on the death of my spouse any accrued or unpaid income shall be paid to my spouse’s estate.

1.2 Discretionary Payment of Principal. Beginning with my death, the trustee may pay to my spouse as much of the principal as the trustee from time to time considers necessary for the health, education, support, or maintenance in reasonable comfort of my spouse.

1.3 Power of Appointment at Death. On the death of my spouse, the trustee shall distribute the principal not required for payment of the Marital Trust Death Taxes to any one or more of my descendants, or any one or more charitable organizations which shall then be in existence as entities described in Sections 170(c) and 2055(a) of the Code, as my spouse appoints by Will, specifically referring to this power of appointment.

1.4 Distribution on Termination. On the death of my spouse, the trustee shall distribute the Marital Trust as follows:

(a) Make-Up Charitable Gift. The trustee shall distribute the Marital Trust principal not required for payment of the Marital Trust Death Taxes, not otherwise effectively appointed, to Madison Youth Programs, if it is then in existence, for its general charitable purposes.   

(b) Child’s Separate Trusts. I give the principal of the Marital Trust not required for payment of the Marital Trust Death Taxes and not otherwise effectively appointed, which shall remain after the application of subparagraph (a) of this paragraph, to the trustee to allocate in shares of equal value for my then living children, subject to the Child’s Separate Trust withholding provisions hereof; provided that if a child of mine shall not then be living but a descendant of the child shall then be living, the trustee shall distribute the share that would have been allocated for the deceased child, if living, per stirpes to the child’s then living descendants.

Proof in the Post-Mortem Pudding

The engineering occurs after the first spouse passes away. A distribution is made to the marital trust. Then, the practitioner begins his work.

The client can make a QTIP election over a fraction of the marital trust for state or federal purposes. Assume a $4 million state exempt trust is needed and a $5 million federally exempt trust is needed as to total property in the trust of $10 million. The federal QTIP percentage is then 5/10 ($5 million out of $10 million), and because a $1 million trust is needed for state QTIP purposes, your client elects 1/10 ($1 million out of $10 million) for state QTIP over the full property (essentially 20 percent of the non-QTIP portion). 

Three shares then: (1) 50 percent is federally elected QTIP; (2) 50 percent has no election over it for federal purposes; and (3) as to that 50 percent over which no QTIP election is made, 20 percent of that (10 percent overall) has a state QTIP election. All three shares are created as separate subtrusts prior to the filing of the federal estate tax return, nine months after the date of the client’s passing. And, at that time of creation and funding, the trustee should fund and divide the trust into separate trusts, using date-of-funding values to satisfy these fractions.

And, the estate planner’s world pre-mortem is perhaps a happier place.                        

Endnotes

1. Private Letter Ruling 201603004 (Aug. 11, 2015).  

2. Hence, we’re left with the quandary, does the Internal Revenue Service really mean what it’s saying in the revenue procedure and the recent PLR, or are those two pronouncements going to be limited to their facts? I’m speculating the latter.

3. This flexibility would be eliminated if the IRS interprets Revenue Procedure 2001-38 not to allow for qualified terminable interest property (QTIP) elections when there’s no estate tax. In that instance, though, the flexibility for planning for portability will become more difficult in all settings, whether it’s a single fund QTIP or a credit shelter trust. 

4. See ibid., though, because the impact of Rev. Proc. 2001-38 isn’t yet known.